High-yield lite fuels fears

Thu May 29, 2014 6:13pm EDT

* Bond covenant quality erodes in hot market conditions

* Almost 20% of deals issued in Q1 were high-yield lite

* High-yield returns still too attractive to turn down

By Mariana Santibanez

NEW YORK, May 29 (IFR) - Junk-bond investors are passing up traditional protections in their race to buy new debt, and some participants worry the diminished safeguards are a sign of an overheated market.

One of the most troubling developments has been the rise of high-yield lite bonds that give issuers wide berth but leave bondholders facing especially heavy losses in case of default.

Combined with yields hovering near record lows for the asset class, the eagerness with which investors are dispensing with typical safety nets could mean trouble ahead.

"A low-rate environment is eroding covenant quality, which recently reached an alltime low and is showing few signs of improving," said Alexander Dill at Moody's Investors Service.

"It shows investors are willing to give up protections in search of yield."

Moody's said that, on a three-month rolling basis, covenant weakness in bonds rated B1 and lower reached the highest in April since the rating agency began tracking it in 2011.

More than 19% of issuance in the first quarter of 2014 has been high-yield lite, which is almost triple the figure in the same period three years earlier, it said.

High-yield lite bonds do not have debt incurrence or restricted payments covenants. The debt incurrence covenants restrict a company's ability to add more debt while restricted payments covenants limit what the issuer is allowed to do with cash or other assets generated.

Those structures give borrowers freedom to increase leverage or make acquisitions even if their businesses are struggling, which makes already risky structures riskier still.

Recent notable high-yield lite deals include April trades from natural gas giant Cheasapeake and debt-laden media company Clear Channel Communications.

Clear Channel refinanced 2016 maturities that many in the market had previously thought were headed for default - and did so with a 10% coupon high-yield lite deal.

"What we are seeing are capital structures getting pushed to the max, and terms becoming issuer-friendly," said Richard Zogheb, co-head of capital markets origination for the Americas at Citi.

LOW RETURNS

Overall, investors are embracing greater risk in exchange for relatively little yield.

Unlike the juicy double-digit coupons from Clear Channel, for example, returns on offer are close to record lows for the asset class.

The yield-to-worst on the Barclays high-yield index dropped to 5.03% on May 28, within spitting distance of the record low 4.95% marked on May 9, 2013.

Predictably, the combination of low-cost funding and reduced protection for bondholders has brought junk-bond borrowers to the market in droves - especially as the Fed was also trimming its asset-buying program.

Supply since the start of April is at nearly US$71.5bn, ahead of the US$67.9bn in the same period a year ago. Year-to-date volume, which was down some 20% from 2013 at the end of the first quarter, is now down just about 10%.

"As the Fed scaled back its bond purchases, issuers began to get more nervous that the market would turn negative," said Zogheb. "So they have been accelerating their deals."

Yet the diminished yields do not seem to be a problem for investors.

According to data from Bank of America Merrill Lynch, high-yield has returned around 4.38% this year, which is ahead of the equity markets which returned 3.88% year-to-date.

"Volatility is low, defaults are low and growth is steady," said Stephen Kotsen, a high-yield portfolio manager at Nomura Corporate Research and Asset Management.

And many market participants insist the market is not back to the boom and bust days of the leveraged buyout boom.

"You are not seeing challenged credits come to market like we saw in 2006/2007," Zogheb said.

SAFE PLAYS

Indeed, despite the erosion of investor protections, defaults do not seem to be on the rise - in part because investors have been willing to help issuers like Clear Channel push out maturities.

The US high yield par default rate was 13.7% in 2009 and 2.8% on a trailing twelve month basis through April 2014, according to Fitch Ratings.

Even so, Fitch has warned that the level of riskier debt in the market is significant.

It said US$403bn in notes rated B minus or lower are currently outstanding - way up from US$354bn at the end of 2009 and the even lower US$329bn at the close of 2011.

And leverage is on the rise too - another warning sign.

Aircraft component maker TransDigm, for example, last week managed to attract more than US$8bn in demand for a new deal to partly finance a dividend. Though it had covenants, the deal took leverage up to 7.4 times - well past the 6.0x level regulators have warned underwriters not to surpass.

"When companies could only get 5.5x leverage a year or so ago, some can now get a low 7x," Zogheb said. (Reporting by Mariana Santibanez; Editing by Natalie Harrison and Marc Carnegie)